Central Garden & Pet Company: Trading At Fair Value (NASDAQ:CENT)

After an impressive run-up in price, shares in Central Garden & Pet Company (CENT) are taking a breather, retracing from their 52-week highs, and currently trading at $37.8 per share.

The company has benefited from the change in consumer behavior as restrictions were placed to combat the spread of COVID. We have seen that strength translate to retailers such as The Home Depot (HD), Tractor Supply (TSCO), and competitor Scotts Miracle-Gro (SMG), all showing impressive year-to-date results and pointing to an industry enjoying the tailwinds from a shift in discretionary spending towards categories such as gardening and pets, as consumers find themselves with more time spent at home.

As it relates to CENT, the company’s Q3 was its best-performing quarter in its history driven by robust consumer demand. The company ended the quarter with $495M in cash and a leverage ratio of 2.4x, within management’s targeted range.

While the company still expects strong demand in Q4, management guided for a slight earnings loss in Q4 as they increase levels of spending towards e-commerce, digital marketing, and cost control measures. As a result, management expects full-year EPS to be at or above $1.90, implying negative EPS of minus $0.08 in the upcoming quarter. However, it’s important to keep in mind that Q4 is the smallest earnings quarter for the company. For example, in Q4 of 2018 and 2019, the company did $0.03 and $0.04, respectively in diluted EPS.

From a valuation point of view, the company is trading at a forward P/E multiple of 19x, approximately in-line with its 5-year average of 22.8x. We believe CENT is trading at fair value and the stock price is already pricing in the favorable outlook for CENT’s business segments (mainly Pet products and Garden Products). We also believe revenue growth through acquisitions might be hard to come by in a hot market. M&A has been the main growth driver for CENT, having completed 50 acquisitions since 1992. However, with strong tailwinds lifting the sector, management might have trouble finding a suitable deal at a reasonable valuation.

To sustain forward earnings of 18x, organic growth needs to remain resilient, which would depend in part on how the pandemic develops in the upcoming quarters. If a vaccine takes longer than expected, then it is reasonable to assume consumers would keep spending their discretionary incomes towards categories such as pets and gardens.

That said, with CENT trading at a fair value multiple, we would rather wait for a bigger margin of safety before initiating a position to account for the unpredictability of the current market. We are neutral on the company.

Tailwinds drove CENT’s best quarterly results

CENT reported third-quarter sales of $833M, up 18% on a year-over-year basis, and beating expectations by $110M. The company also reported a GAAP EPS of $1.27, beating the consensus by $0.43.

There was strong demand for both CENT’s product segments. The company experienced organic sales of 18% in Garden, and 15% in Pets compared to the prior-year period.

Operating margins

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Is Central Garden & Pet (NASDAQ:CENT) Likely To Turn Things Around?

If you’re not sure where to start when looking for the next multi-bagger, there are a few key trends you should keep an eye out for. Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Basically this means that a company has profitable initiatives that it can continue to reinvest in, which is a trait of a compounding machine. Having said that, from a first glance at Central Garden & Pet (NASDAQ:CENT) we aren’t jumping out of our chairs at how returns are trending, but let’s have a deeper look.

Return On Capital Employed (ROCE): What is it?

Just to clarify if you’re unsure, ROCE is a metric for evaluating how much pre-tax income (in percentage terms) a company earns on the capital invested in its business. To calculate this metric for Central Garden & Pet, this is the formula:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets – Current Liabilities)

0.098 = US$184m ÷ (US$2.3b – US$385m) (Based on the trailing twelve months to June 2020).

Therefore, Central Garden & Pet has an ROCE of 9.8%. In absolute terms, that’s a low return and it also under-performs the Household Products industry average of 16%.

View our latest analysis for Central Garden & Pet

Above you can see how the current ROCE for Central Garden & Pet compares to its prior returns on capital, but there’s only so much you can tell from the past. If you’d like to see what analysts are forecasting going forward, you should check out our free report for Central Garden & Pet.

What Can We Tell From Central Garden & Pet’s ROCE Trend?

In terms of Central Garden & Pet’s historical ROCE trend, it doesn’t exactly demand attention. Over the past five years, ROCE has remained relatively flat at around 9.8% and the business has deployed 96% more capital into its operations. This poor ROCE doesn’t inspire confidence right now, and with the increase in capital employed, it’s evident that the business isn’t deploying the funds into high return investments.

In Conclusion…

As we’ve seen above, Central Garden & Pet’s returns on capital haven’t increased but it is reinvesting in the business. Investors must think there’s better things to come because the stock has knocked it out of the park delivering a 159% gain to shareholders who have held over the last five years. Ultimately, if the underlying trends persist, we wouldn’t hold our breath on it being a multi-bagger going forward.

On a separate note, we’ve found 1 warning sign for Central Garden & Pet you’ll probably want to know about.

While Central Garden & Pet isn’t earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and

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